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GRAND RAPIDS — According to a bulletin from Aon Consulting, the IRS suddenly is starting to perk up its ears and sniff energetically at a new mode of taxing employees who are part of so-called split-dollar insurance policy contracts.

In a traditional split-dollar arrangement, an employer pays the premiums for a whole life insurance policy upon an employee. The employee designates the policy's beneficiary and is regarded by the IRS as receiving a taxable benefit.

Should the employee die, the beneficiary receives the policy's face amount — the death benefit — and the employer receives whatever cash value has built up in the policy. Likewise, should the employee leave for another job, the employer cancels the contract and is entitled to the policy's cash value.

The theme has numerous variations: so-called equity policies in which the employer receives a share of the death benefit large enough to defray the premiums it paid; reverse arrangements, in which the employer is the beneficiary and the employee has claim to the cash value; and yet other situations in which employee and employer pay agreed-upon shares of the premiums, the employee's share being a deduction from his or her taxable benefit.

What the IRS traditionally has done is tax the employee on the value of the death benefit as expressed in terms of so-called one-year term insurance rates, with added taxes if the employee also is the recipient of policy dividends or added paid-up insurance.

What the IRS proposes now is an updated table of mortality rates for valuing split dollar arrangements and qualified retirement plans. Explicitly, the IRS wants to require that one-year term insurance rates aren't just low fantasy rates, but actual rates at which the insurer regularly sells term insurance to other standard-risk customers.

The distinction is important, for standard one-year term insurance rates tend to rise sharply in the middle years and afterward.

For now, according to Aon, the IRS is using a transition rule which allows taxpayers to continue using the old one-year rates until Dec.31, 2003.

After that, the consulting firm says, even the IRS isn't certain about what it’s going to do.

But for now, it appears that employees may choose one of three taxation alternatives to apply to equity split dollar arrangements:

Premiums taxed as compensation — This would occur in instances where an employer has no interest in the policy's cash value or any expectation of recovering premiums. In a case where the premiums are taxed as compensation to the employee, the employee would not be required to report any income for the value of the death benefit protection or to declare cash build-up as income.

Premiums taxed as interest-free loans — In this situation, the employee is treated as paying the employer nondeductible interest at a rate equal to the difference between the interest rate, if any, on the loan and the applicable federal rate (currently 5.61 percent), while receiving from the employer payments equal to the imputed interest, which payments are treated as compensation.Under this method of taxation, the employee again need not report any income for the value of the death benefit protection or to declare cash build-up as income.

In reverse split-dollar contracts, cash value build-up can be taxed as a transfer of property — This is consistent with IRS rules which regard a life insurance policy to be property insofar as its cash value is concerned. Thus an employee would have compensation income to the extent that he or she acquires "a substantially vested interest" in the cash value that exceeds the amount, if any, that the employee pays to acquire that interest.

What the IRS hasn't clarified at this point is how it would choose to levy its tax against a transfer of property.

Aon speculates that three routes are possible: annually, as the employee has access to the cash build-up; at the termination of the contract after the employer recovers its interest in the cash value; or, when the employee actually receives the cash build-up.

Whatever the method, Aon believes split dollar arrangements still retain tax and financial advantages, though the proposed IRS rules may increase the taxable value of a policy's death benefit.

Aon recommends that employers and employees with existing split-dollar contracts consult tax and finance professionals about the several ways to deal with the issue between now and 2003.

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